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December 28, 2012

Interest-Rate Risk's Ticking Time Bomb: News Analysis

Rising rates that escape the Fed’s rate suppression efforts may be all it takes to set off sustained political and economic crisis in the U.S.

As we lie perched on the fiscal cliff’s very precipice, it’s worth considering for a moment the dog that has not barked amid all the economic tumult of recent times: interest rates.

The Fed has succeeded, so far, in maintaining near zero rates. This zero-rate policy has encouraged investors to participate in financial markets, both stocks and bonds. If rates should spike, unexpectedly, stocks and bonds are likely to take a significant hit.

So too at the macroeconomic level, a rise in interest rates would be a game changer.

We already devote 6.31% of the budget to service the debt. That’s significantly more than we spend on all U.S. military personnel. It’s more than the combined total of what we spend on unemployment insurance, earned income and child tax credits and housing assistance to the poor. It’s one of the biggest single items in the federal budget.

If rates rose, all the political deals Democrats and Republicans have hinted at but not had the courage to adopt will instantly be deficient in revenue by tens of billions of dollars. (We’re currently spending $220 billion in annual net interest payments.)

To be clear, rising rates is not inherently a bad thing. It could even be the best thing that could possibly happen since Americans would once again be rewarded for the discipline of saving and politicians would be forced to make real choices between guns and butter.

But realistically, the void of leadership today signals a different path, specifically that the slow-motion train wreck Europe has been going through for the past three years may be our fate as well.

A little history will help. Europe’s various sovereign debt crises started when investors began to doubt Greece’s ability to pay its bond investors.

Bond yields and the cost of credit default swap insurance rose. When Greek bonds were downgraded to junk status, the EU and IMF crafted a bailout package.

But what seemed at the time to be a temporary scare that European Union summiteers would make go away has only widened in a domino-like chain of misery, first to other “peripheral” European countries, but soon enough to Europe’s wealthy core.

It is not outlandish to expect the fiscal cliff to be the start of America’s sovereign debt problem that just won’t go away.

That’s not how Americans currently view the problem. We had a debt ceiling crisis in the summer of 2011 that ended when politicians crafted a legislative compromise that included an expiration of Bush-era tax cuts and across-the-board spending cuts. The agreement also created a joint select committee – remember the “supercommittee”? – that was supposed to come up with more nuanced revenue hikes, spending cuts and tax and entitlement reform that would avoid the pain of sequestration.

The not so super committee utterly failed to reach any agreement and the country waited a year, post-election, for the president and the current lame duck Congress to solve the problem. As we know, only Sunday and Monday remain as working days and so far there’s no deal in sight.

In any event, what may seem to Americans as an annual budget crisis, recurring at the end of each year, could starting now morph into a more European style perma-crisis.

Of course, the Fed has no intention of raising rates any time soon, but markets can raise rates. The rise in rates on Greek bonds is what lit the fuse of Europe’s economic crisis after all.

A year ago, when S&P lowered its credit rating on U.S. government debt, the stock market fell 5.6% in a single day. But the other shoe – the bond market – never dropped. With Europe deep in crisis and stock markets worldwide falling, U.S. Treasuries were ironically seen as a safe haven.

We can’t assume that will recur. Markets make unexpected moves. A bond market crash could occur if ratings firms move to downgrade U.S. debt after the fiscal cliff goes unresolved; or perhaps the market will crater if an ultimate tax on the wealthiest Americans brings in little (or declining) revenue, as has occurred in the U.K. recently.

Rising long-term interest rates could have devastating consequences for all the banks and insurance companies that have been lured by the Fed into buying bonds. The value of their portfolios would tank. For consumers buying mortgages or borrowing at today’s cheap rates, these are the best of times for debt.

But suddenly and unexpectedly, we may be entering a time when debt is as cool as another failed Euro-summit.